Proxy Statements: What They Are and Why You Should Read Them

The SEC is a sea of paperwork. Every single day of the week, thousands of financial documents are filed and stored in an online database. Keeping up to date with just one company is hard enough. Keeping up with every filing from every company is virtually impossible.

You have to prioritize your time and read only the most important filings. Most investors do this by reading annual and quarterly reports, but I think investors would be well served to read the proxy filings, too. Here are 3 very important things you'll find tucked away in a company's proxy statement.

1. Key executive biographies and backgroundBoard members exist for one primary reason: To hire and fire the CEO and provide some high-level insight on how to run the business.

General Mills is an interesting case in board construction. Its board includes 13 members including its CEO, Kendall Powell. Member backgrounds vary from former medical company CEOs, to the former CEOs ofBest BuyandOffice Depot. In addition, the board includes two professors of law and business. Former and current bankers and investment professionals round out the list.

Only one board member -- the current CEO -- has any notable experience in General Mills' core business of packaged foods. Is General Mills' board of directors capable of questioning the CEO's strategy? I would think not.

Conversely, other corporate boards are stacked with directors with relevant experience. Take Boston Beeras an example. Its board of directors is comprised of the founder and major shareholder, as well as its current CEO. In addition, it counts the current CEO of Dean Foods, a former winery Chairman, and the current CEO of a coffee and tea company on its roster of directors.

Which board has more relevant experience? Boston Beer, by a landslide. It won't matter when times are good and CEOs are lauded for strong performance. But should tides turn, you want board members who can question a CEO's strategy and, more importantly, know which candidates are best fit to lead the company should it ever need a new CEO.

2. Board compensation and attendanceAs a rule, board members have the best job on Earth. They are paid handsomely -- tens of thousands of dollars per hour of actual work, in some cases.

The proxy filing discloses the "director fees" board members earn serving in various capacities on the Board of Directors and the smaller committees.To find board compensation, look for a table such as the one below, which appeared in General Mills' 2014 proxy filing.

In general, it's good to see that a board member's interest in the company goes beyond compensation. It's one thing to collect $300,000 in annual compensation for serving on a corporate board. It's another thing all together to collect $300,000 in fees but have $50 million riding on the company's stock. Outside investors typically make for better board members, since they're most interested in improving the performance of the business and its stock price, not collecting another year's worth of director fees.

3. Executive compensationIf you read nothing else, read this part of a proxy statement. It is human nature to make decisions that maximize your compensation, and corporate managers are no exception. The best companies will plainly disclose the inputs that go into executive pay.

One of my favorite anecdotes about compensation comes fromHertz, the rental car company. Hertz was a subsidiary of Ford Motor, before a private-equity buyout of the company in 2005. Before the buyout, compensation was closely tied to Hertz's market share in the rental car market.

With financial incentives to seek market share at all costs, Hertz opened a bevy of unprofitable offices. Its managers also allowed costs to balloon in its European operations. Surprised? You shouldn't be. If your compensation is tied to your firm's share of the market, you don't have any reason to think about cutting costs or shuttering money-losing stores. More stores and more sales is always good from your point of view.

Not surprisingly, one of the first steps to improving Hertz's performance was replacing its managers' compensation structure. Cash flow and profitability became the main determinants of its managers' bonuses. Under new ownership, Hertz closed unprofitable stores, market share took a backseat to profits, and operations were streamlined to cut costs. Hertz would become tremendously profitable, generating a 30% compounded return over 7 years for its new owners.

With the right incentives in place, corporate managers will break their backs to deliver outstanding returns for investors. The wrong incentives, however, encourage the destruction of shareholder wealth for the benefit of the management team. To borrow a popular phrase among economists, "incentives matter."

Make the proxy statements a key part of your processWe all have a different investment process, but I'm certain that every investor could improve their performance by reading the proxy filings for every company they invest in.

The proxy filings lay the groundwork for understanding how a company's management team thinks, what metrics are important for the business, and whether or not the company is managed by insiders who have a vested interest in the success of its shareholders. These are vital pieces of information that no investor should go without.

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Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Boston Beer and Ford. The Motley Fool owns shares of Boston Beer, Ford, and Hertz Global Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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